What is NDF Market?

In the search for diversification, Indian investors consider various asset classes. Some dive into equities, while others into derivatives. But, the search ends with currency trading for investors who seek quick and high returns. There has been an immense rise in interest in this field, and as a result, the volume of currency trading in India. However, some investors believe that the Indian currency market is highly regulated and involves cumbersome documentation, extensive Know-your-Customer requirements, and rigid rules and guidelines. This results in a misconception that their profit potential is affected in the long run.

Investors who do not want to tackle such regulations ensure that they trade in currencies in a market that is flexible and is not regulated by the Reserve Bank of India. Such investors use NDF or Non-deliverable Forwards within the non-deliverable forward market to trade in currency outside India. But before you learn everything about an NDF, there are a few things you should understand first.

What is Currency Trading?

Currency trading refers to the exchange of currencies, where the difference in the currency value is used to make profits. It is a huge market, with the traded value being higher than equities. A few years ago, currency trading was restricted to large banks and corporations. Now, technological advancement has equipped retail investors with easy access to currency trading, and even individual investors consider it an attractive avenue for investment.

The market works on one principle that currencies are always traded in pairs. For example:

• Indian Rupee vs United States Dollar (USD-INR)
• Indian Rupee vs Euro (EUR-INR)
• Indian Rupee vs Great Britain Pound (GBP-INR)
• Indian Rupee vs Japan’s Yen (JPY-INR)

What are the two types of currency markets?

• Onshore Market: Onshore market is the local currency market of the country in which the trader is a legal citizen. For example, for Indian citizens, the forex market in India will be the Onshore market. The rules and regulations are rigid and predetermined, and currency trading comes with numerous tax obligations in an onshore market. Most currency traders restrict their trades in onshore markets as they are better equipped to understand the factors that may affect the prices of the currencies. It is also easier for them to trade in the onshore market.

• Offshore market: Simply put, an offshore market refers to a location that is outside a trader’s home country. For example, if you are buying currencies from London’s currency exchange, the trade would be known as offshore market trade. In an offshore market, the rules and regulations may be flexible and can allow traders to decrease their tax obligations.

What are Forward Contracts?

A forward contract, also known as forwards, is a private agreement between two parties to purchase or sell the underlying asset at a predetermined time at a specific price. Any forward contract is subject to both market risk and credit risk. You can know about the profit or loss accruing from a forward contract only at the date of settlement of the contract. You can have a forwards contract for trading in different OTC derivatives, such as stocks, commodities, and so on. It can provide you with greater flexibility with the terms of trade. For instance, in India, you can have a forward contract for currencies, which are outside the specified list by stock exchanges.

What are NDFs?

An NDF is a short-term, cash-settled forwards contract that investors use to trade in currencies in an offshore market. The two involved parties create a settlement between the contracted NDF rate and the leading spot price when both parties agree on a notional amount. NDFs in the non-deliverable forward market are always settled in cash and are non-deliverable, meaning the trader can not take the delivery of the currencies.

How does a Non-deliverable Forward market work in India?

The non-deliverable forwards market works with the exchange of cash flows between the two parties based on the NDF price and the prevailing spot price. In the transaction, one party agrees to settle the contract by paying the other party the difference resulting from the exchange.

These contracts are OTC (over-the-counter) and are usually settled in the offshore currency market. For example, if a currency is restricted to be traded outside the country, it becomes impossible to settle trade with someone who is outside the country. In this case, the parties use NDFs within the non-deliverable forward market that converts all the profits and losses to a freely traded currency in both countries.

Example of an NDF Market

Suppose one party agrees to buy Japan’s Yen (sell dollars), and you decide to buy US dollars (sell Japan’s Yen), then you can enter into an NDF within the non-deliverable forward market. In this case, assume that the agreed rate is 11.5 on US dollars 1 million and the fixing date is two months.

After two months, if the rate is 10.5, Japan’s Yen has increased in value, and you owe the other party money. In case the rate increases to 12, you will receive money from the other party.

NDFs within the non-deliverable forward market are used daily in high volume by Indians, making the NDF market in India an exciting one. You can also consider trading in currencies through NDFs if you are looking for quick profits. However, it is advised that you consult a financial advisor such as IIFL to understand your tax and legal obligations.